Opinion: Why building new refineries in Canada is uneconomic and undesirable

During the past decade Canada’s upstream oil and gas sector invested well over $100-billion in acquiring access to resource, innovative technologies and the necessary talent to bring our domestic production of liquid hydrocarbons to almost 4 million barrels of oil equivalent per day. The investments made a tremendous contribution to the Canadian economy and were among the key reasons our nation faired better than most during the economic turmoil that shocked our G8 peers over the past five years.

It is estimated that a further $218-billion will be spent over the next 25 years to boost production to almost seven million boepd. This from a nation of 35 million citizens consuming just over two million barrels per day.

The ultimate profitability of that investment and our future economic outperformance is now balanced on a fulcrum that is the midstream sector. We need to expand our capacity to process and move hydrocarbons to market in conjunction with rising production. Judging by the result of separate polls conducted by IPSOS and Harris-Decima earlier in the fall, most Canadians now appreciate that and they want facts to enable better decision making.

Curiously the support for Enbridge Inc.’s reversal of Line 9B and TransCanada Corp.’s proposed Energy East project is very high at between 60-80% while backing for other high profile projects such as Keystone XL and Northern Gateway are closer to 50%. Presumably much of the difference in opposition to those projects is over the belief that we should be upgrading and refining all of our production domestically. This is the premise of the NDP’s opposition to both projects.

Notionally it is nice to think that in the absence of pipelines that industry would invest the tens of billions necessary to refine all our production at home. That may appeal to some as good politics but it is economically naive and just plain bad business. Moreover it undermines our geographic competitive advantage.

An examination of the facts should help Canadians understand why this posit is uneconomic and subsequently undesirable.

The economic value of liquid hydrocarbons is derived from the incredible amount of energy stored in and myriad of products that can be produced from them. To unlock this potential requires processing and refining. Refineries are big, complex manufacturing-like facilities that are expensive and time consuming to build, never mind the regulatory hurdles and delays required to get them approved. In the past 30 years there has been only one new refinery started in Canada and that is the North West Redwater Partnership that broke ground in September. Over that same period Quebec lost four refineries and Nova Scotia lost one just last year. With one notable exception the trend has been to close them rather than build new ones.

This has left Canada with approximately two million barrels refining capacity or just over 50% of current production. Western Canada has 683,000 barrels per day of capacity with plans to add up to as much as 675,000 barrels of capacity (Redwater’s 150,000 bpd capacity and David Black’s ambitious 500,000-barrel Kitimat proposal).

In Ontario there are four refineries with combined refining capacity of 393,000 barrels per day capacity. Quebec has two remaining refineries with total capacity of 402,000 bpd and Atlantic Canada has three with 503,000 bpd of combined capacity. That brings current and proposed capacity to just 2.65 million bpd The Natural Resources Canada website reports that existing capacity already produces 10% more refined products than we use domestically. Should we double our refining capacity and if so, where are the markets for refined products?

Building a new refinery is estimated to cost four times as much as retooling and expanding an existing one. So before answering the question we should consider the capacity that currently resides within the borders of our neighbour and largest trading partner.

The US Department of Energy divides the country in to 5 Petroleum Administration Defense Districts, commonly referred to as PADDs. Across the U.S., there is approximately 19 million barrels per day of refining capacity. This exceeds domestic demand which has peaked in recent years. Subsequently there is some spare capacity.

The spare capacity exists primarily in PADD III along the Gulf Coast where there are some 50 refineries and a total of 9.4 million bpd of capacity. During 2012, foreign sources supplied 4.4 million bpd, 50% of which was heavy oil. Due to limited pipeline infrastructure only 100,000 bpd of western Canadian crude was able to reach this refining complex. Most of our exported volumes were being held up in PADD II where rising Bakken and Canadian production provided more than the 3.4 million bpd of capacity could operationally utilize. Subsequently storage has been filled and a significant discount to WTI has emerged. Moving production through PADD II on to the refining complex at PADD III will help alleviate the differential issue and return some lost revenues to Canadian producers and governments.

These Gulf Coast refiners enjoy a geographical advantage of being close to the export markets for refined petroleum products. These are located in Latin America, the Caribbean and North Africa. Conversely Canada has a geographical advantage in servicing the Asian markets of Japan, Korea and China via the North Pacific trade route. These industrialized markets are primarily seeking raw materials to feed their own refining industry. Who would make the financial investment necessary to build new refineries in Canada knowing that the excess capacity existing in the U.S. enjoys a capital and geographic advantage for exporting refined products?

We need to compete where we benefit from natural and cultural advantages otherwise we risk significant economic loss. We can and do add value to our hydrocarbon industry by developing innovative new technologies to responsibly recover and transport them. We can then export that technology and expertise in the form of licensing, sales and joint ventures. This is already been done with impressive results by companies such as Computer Modelling Group Ltd., Packers Plus Energy Services Inc. and Trican Well Services Ltd. to name but a few.

The members of the NDP and other groups and individuals that support domestic pipelines but not export pipelines to tidewater are well intentioned in that they presumably seek to maximize the economic potential of our natural resources. However, they must be cognizant of the fact that expanding domestic refining capacity with the intention of exporting refined products ignores the huge cost and geographic advantage enjoyed by refiners in PADD III. It also ignores that the markets in which we have a geographic advantage are seeking feedstock. Spending billions to construct and operate new refineries that are competitively disadvantaged would be a misallocation of limited financial resources.

We need to get our product to tidewater to diversify our customer base and to improve pricing. The Keystone XL and Northern Gateway projects in no way undermine Canada’s economic interest. Rather, they are both aligned with the realities of the industry and our geography. From an economic perspective they should both proceed.

David A. McLellan is a Calgary-based oil and gas professional and is a student in the University of Tulsa’s Master of Energy Business program.